Do We Need a Reserve Bank? - The Centre for Independent Studies
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Do We Need a Reserve Bank?

There is much dissatisfaction with the performance of central banks because they have a poor record in managing monetary conditions so as to promote stability of domestic prices and foreign exchange rates. Before 1914 there were few central banks and they adhered to a full gold standard, which ensured stable exchange rates and kept inflation within bounds that now appear very moderate. But in the 1920s there were massive gold flows to the United States because of service payments on war debt, new protective tariffs that impeded exports to the United States, and then foreign participation in the Wall Street stock exchange boom.

In these years the new Federal Reserve System imposed severe deflation on other countries by sterilising the gold inflows and, in the Great Depression, the international gold standard broke down. After World War 11 an emasculated gold standard was set up under the Bretton Woods Agreements, which required member countries to peg their currencies to the US dollar by fixing a par gold value, and by limiting their power to vary that parity. These arrangements worked fairly well in the 1950s but, in the following decade, the Federal Reserve accommodated huge US budget deficits and so brought about a serious and world-wide inflation, Such has been the record of the world’s dominant central bank.

The United States went off gold in 1971, and floating exchange rates replaced fixed rates. Since then the external values of currencies have come to depend on changing agreements made between governments or central banks and upon the unstable expectations of dealers in foreign exchange markets that have greatly expanded with widespread financial deregulation. As John Hicks put it, the world is really managing without money in the sense that there is no longer any international money, i.e. money tied to gold or to anything else that is internationally acceptable. That, of course, is economically damaging because there is added to the inevitable uncertainties of business new or greater uncertainties relating to inflation, exchange rates and interest rates, which central banks try to manipulate for reasons of internal or external policy. Among the adverse consequences have been damage to investment and saving, distorted allocation of productive resources, speculative gains of wealth not matched by productive contributions, and loss by
those least able to shield themselves from uncertainty.

Some central banks, of course, have behaved worse than others. There is a close association between the degree of their subservience to government and the rate of inflation. The Bundesbank is very independent and West Germany has had consistently low rates of inflation. The Bank of England and the Reserve Bank of Australia are very much under Treasury control and their countries have had rates of inflation well above the OECD average. It is not surprising that attention is being paid to ways of reducing such dependence, and recently The Economist has proposed the Netherlands Bank as a model. This central bank has freedom to follow its own policies which the government can override only if it publishes both the bank’s case for the disputed policy and its own objections to that policy. Public opinion in the Netherlands is sufficiently well informed to have deterred the government from exercising this power of overriding the bank bank. New Zealand has taken some steps under a new Act to make its Reserve Bank more independent, but the Australian government has taken an opposite course by translating its Secretary of the Treasury to the Governorship of the Reserve Bank.

It is against this kind of background the Centre for Independent Studies organised in September 1989 two seminars (in Sydney and Wellington) on banking without central banks. At each seminar Professor Lawrence White, an expert on free banking from the University of Georgia, presented a paper on depoliticising the supply of money.

White argues that the best monetary system would be one in which private banks were free to issue their own currency subject to a legal requirement of convertibility into “a standard basic asset”. (This, as commentators pointed out, was the system that prevailed in Australia and New Zealand before they established their central banks.) He is dismissive of proposals for making central banks independent, but without reference to German or Dutch experience. Nor does he favour having central banks bound by a firm rue: for limiting the growth of the money supply, as Milton Friedman had proposed. There are, he thinks, too many possibilities of politicians changing partial independence or a monetary rule. But experience, such as that of  the free banking system which used to prevail in Scotland, has shown that a contractual obligation of convertibility is practical and effective. Under free banking there would be competition between private banks for acceptability of their notes and deposits with the result that good money would drive out bad in accordance with a reverse Gresham’s Law. There would thus be greater stability of money and prices with consequent macro-economic benefits.

The other two main speakers, Chris Jones and Bryce Wilkinson, arc sympathetic towards Professor White’s ideas. The two discussion panels, however, are notably different both in their views about free banking and in the range of topics raised. The Australian panel concentrates on exploring the scope and mechanisms of free banking in both the past and the present. The New Zealand panel is somewhat more critical of the idea; its members are inclined to look for areas where continued central bank activity might be
beneficial. Most challenging of all is Jan Whitwell’s insistence that the world’s recent economic disorders have resulted from the inherent instability of free financial markets rather than from the activities of government agencies.

There are, then, some conflicts of views about reforming the banking system so as to limit the recurrence of its recent results, which all judge to have been quite unsatisfactory. What is important, and makes me commend this book, is that there is informed discussion of these problems and that such discussion is brought to public notice. In a democracy, that is the best prospect for worthwhile reforms being made. I would add that the problems are long overdue for resolution; for they engaged the close attention of Lord Keynes during the 25 years that preceded his death, and still persist 45 years later.